If Fund of Hedge Funds Are To Thrive...

Niki Natarajan, Editor of InvestHedge, surveyed the 103 funds of hedge funds that comprise of the InvestHedge Billion Dollar Club.  61% of respondents believed that consolidation would continue over the next five years while  76% of the same firms were planning to grow their funds internally.  On June 2007, 147 funds managed $956 billion.  In October 2012, 78 funds in the club had survived the credit crisis of 2008 and they managed only $538 billion.  The top ten funds in 2007 have lost 49% in assets under management.

The club members believe that they can grow by making acquisitions of other funds of hedge funds, merging into investment banking advisory or private equity firms, creating customized portfolios and sourcing new hedge fund managers.  Deals have made the biggest headlines this year.  The Man Group is buying Financial Risk Management.  Crestline Investors is buying Lyster Watson's fund of hedge fund business.  UBP Alternative Investments is buying Nexar Capital Group.  In the pipeline are mergers between  Kenmar Group and Olympia Capital Management and Rothschile & Cie Gestion and HDF Finance.  Some examples of funds joining advisory or private equity firms are ABS Investment Management joining Evercore and  Prisma Capital Partners joining KKR.

Blackstone Alternative Asset Management is the largest fund of hedge fund manager with $41 billion in assets.  Its growth strategy is customizing portfolios, advisory work and providing seed capital to emerging hedge funds.  Since 2007, its assets under management has grown 96%.

The source for this article can be accessed here.

Warehousing for a Commodities Trade

Traders from specialist commodities firms and, to a lesser extent, banks are buying warehouse in various port cities to store metals for "financing deals".  They buy metals from mining companies and sell it for delivery in the future.  This trade makes money when the market is in contango, when futures prices are higher than current (spot) prices.  The traders only have to ensure that storage costs are less than the profit from the trade.

The London Metals Exchange (LME) restricts how much metal can be shipped on a daily basis.  Meanwhile, buyers have to pay storage costs until they can be released.  Usually, metals manufacturing companies obtain their metals from producers using fixed long-term contacts.  If their business plan projections are too low, then they have to buy more on the market which has much higher prices than the LME.

For example, Pacorini Metals, a unit of commodity trader Glencore, has enough warehouses to store two million tons of aluminum - about 20% of the total stock.  Glencore will also buy 15.4 million tons of aluminum over the next seven years from Rusal, a Russian company.  There is an inherent conflict of interest that is being managed within the firms "Chinese Walls".  These firms have insight into one of the key pricing factors for the commodity, the amount of metals released as dictated by LME rules.  This gives them an edge when trading for their own accounts.  The LME is conducting a review of its processes.  Chief Executive Officer Martin Abbott believes that these warehouses are used primarily for "financing deals" and because the rate of delivery is low or because of the warehouse conflict of interest.

The source for this article can be accessed here.

Hedge Funds and the Credit Crisis

The RAND Group published a paper examining the role of hedge funds during the credit crisis of 2008.  The question was whether or not funds create or contribute to the systemic risk that caused it.  This was triggered when Lehman Brothers declared bankruptcy and caused the financial markets to melt down globally.  The researchers reviewed that crisis and the 1998 private bailout of Long Term Capital Management orchestrated by the Federal Reserve.  They found six areas of concern:

• Lack of information on hedge funds
• Lack of appropriate margin in derivative trades
• Runs of prime brokers
• Short selling
• Compromised risk management incentives
• Lack of portfolio liquidity and excessive leverage

Dodd-Frank legislation was passed to handle these issues to avoid new crises in the future.  To create more transparency on hedge funds, the reform was to require funds with $150 million in assets under management to register with the SEC.  However, there is a loophole as non-US hedge funds with no offices in the US and less than $25 million invested from US investors were exempt from the reporting requirement.  There is pending legislation from Europe that would affect those hedge funds but no reform in Asia is anticipated.  Funds are to submit the following data points:  assets under management, total leverage, counterparty credit risk exposure, trading and investment positions, asset valuation processes, asset types, side arrangements or letters with investors and trading practices.  Additionally, the SEC would have periodic inspections of the fund.  Since derivative trades were at the center of the crisis, swap trades need to be registered in a central repository. 

The CFTC and SEC would impose minimum capital restrictions on these trades and the funds must trade them on an exchange if possible.  To prevent funds from closing their prime brokerage accounts, their accounts would be segregated from the prime broker’s funds and rehypothecation of assets would not be allowed.  Rehypothecation is when the prime broker uses the hedge fund’s assets for its own business such as securities lending or as collateral. 

Short selling rules will be enforced to prevent bear raids on a stock.  When a stock falls 10% or more in price from the prior day’s close, then the uptick rule will be triggered.  This rule restricts short sales to when the stock price is above the last sale or the best bid price.   In a short sale, the stock must be borrowed first.  These shares must be delivered by the settlement date (within three days) of the trade.  There must be monthly disclosure of short positions aggregated by stock. 

Dodd-Frank also limits bank investment in hedge funds to three percent of the fund’s assets and three percent of the fund’s tier 1 capital.  Hopefully, this will prevent banks from bailing out their funds.  This is true from a financial perspective but banks may be motivated to bail them out to mitigate reputational risk.  These restrictions are only applicable to US entities.

To address the liquidity and leverage concerns, large hedge funds with $50 billion or more of assets under management are candidates to be regulated by the Federal Reserve Bank.  These funds are determined by the Financial Stability Oversight Council who assesses them based on a wide range of factors; quantitative and qualitative, industry and firm-based and the Department of the Treasury.  If two thirds of the council plus Treasury agree, then the fund will be regulated.  There will be position limits on futures and options for physical commodities and annual stress tests for funds with $10 billion in assets under three scenarios – baseline, adverse and severely adverse.  Regulating the prime brokers of hedge funds indirectly addresses leverage.  They will have higher capital requirements and have less credit to extend to funds, limiting their available leverage.

The reforms are changing the way hedge funds operate.  This is ironic as they did not cause the credit crisis.  The gap is in the potential lack of portfolio liquidity and excessive leverage.   There is too long a time delay before reporting positions.  The number of funds covered are few.  Prime brokers and regulators will have incomplete data as funds use multiple brokers and home countries.   Of the other points, lack of information, lack of margin on derivative trades and runs on prime brokers are strongly addressed and short selling and risk management incentives are moderately addressed.  Regulators should continue analyzing the hedge fund universe to better understand and monitor their risk.

The source for this article can be accessed here.

The Chinese Yuan as a Reserve Currency

The rise of China to become the second largest global economy has allowed it to execute foreign trade and investments using the yuan.  This helps reduce transaction costs for Chinese importers and exporters and reduces volatility for commodities.  China would like to see a basket of possible reserves currencies such as the US dollar, yuan and euro.  Unfortunately, none of them alternatives are realistic.  The euro is facing a crisis and possible breakup.  For the yuan to graduate to become a reserve currency, China would have to increase the limits on capital flows into its markets - allowing securities, currency exchange rates and interest rates to float.  This would degrade the Politburo's control of the country's economic policy.

John Williamson, a senior fellow at the Peterson Institute for International Economics in Washington, identified two advantages of the dollar as reserve currency:  China's large holdings of US assets is used to maintain the yuan to dollar peg but encumbers their policies and the US can enforce financial sanctions.  Other than those items, the US has no freedom to manage its exchange rate.  He predicts that the US dollar will remain the currency for the next 25 years.

The source for this article can be accessed here.

The Yale Model for Individual Investors

A new strategy called "endowment in a box" has been attracting individual investors who want a diversified asset allocation that is predominantly in alternative investment.  It is based on the Yale model made famous by David Swensen at Yale and Jack Meyer at Harvard.  The strategy invests in equities and fixed income securities from around the world and has a high allocation to hedge funds, private equity, real estate and commodities.  Some of the more well known managers are HighVista Strategies, Makena Capital Management and Morgan Creek Capital Management.  I was privileged enough to hear Mark Yusko, CEO and Chief Investment Officer of Morgan Creek, speak at the Hedge Fund Roundtable last year.  Their goal is to have high returns with the least risk possible.

The article provided an inside look at HighVista Strategies which is run by Andre Perold, a former professor at Harvard Business School, Brian Chu, Jesse Barnes and Raphael Schorr.  It has $3.6 billion in assets under management.  It has outperformed the Standard & Poor's 500 index by 15.3% for the period between October 2005 to June 2012.  Dr. Perold has two main tenets:  don't lose a lot of money and get the highest returns.  HighVista invests in the top managers and uses index funds to balance their asset allocation.  56% of the portfolio is in hedge funds and private equity.  The remainder is in cash, global stock indices and bonds.  They are invested in 75 fund managers such as Convexity Capital (fixed income hedge fund), Berkshire Partners (private equity fund) and Xander Group (emerging markets hedge fund).  Another alternative holding is catastrophe bonds that pay off when there is a natural disaster such as a hurricane or earthquake.  For the traditional assets, the rule is:  the higher the risk; the higher the cash allocation.  The equities allocation is based on the VIX index which measures the option market's assessment of future volatility in the S&P 500 index.  The higher the VIX; the lower the equities holdings.

The article from Barron's can be accessed here.

Trends in Tail Risk Investing

310 investors were asked their views on tail risk in today's market environment in a survey conducted by the Economist Intelligence Unit on behalf of State Street Global Advisors.  They were located in the US and Western Europe and consisted of institutional investors (asset managers and pension funds), family offices, consultants and private banks.  The definition of tail risk is an investment that moves more then three standard deviations from a normal distribution (think bell curve) of returns.  Since the 2008 credit crisis, these events have seemingly multiplied.  Adding tail risk protection is becoming part of more investors' asset allocation model.

Traditionally, most managers diversified across the standard equity and fixed income classes along geographic, capitalization and security type.  There was a reduction of 5% of investors in using this strategy, led by institutional investors.  Slightly more consultants, family offices and private banks are using diversification even though the credit crisis showed that all asset classes correlate to 1.  The other strategy to fall was fund of hedge funds due to poor returns, high management costs and the loss of confidence with the Madoff affair.

Strategy winners were managed volatility equity strategies, managed futures and alternative investments such as real estate, commodities and infrastructure.  Managed volatility was increased across the board by the investors with the largest increase by private banks.  There was a split decision on managed futures with private banks and consultants allocating more and institutional investors allocating less assets.  Risk budgeting was stable overall with the institutional investors decrease in that strategy offset by the increase by private banks.  Direct hedging was unchanged as institutional investors and private banks doing more and consultants and family offices doing less.  The same split occurred with hedge fund investing.

Seven main factors affected investors' choice of tail risk strategy.  They are, in order of importance, liquidity, regulatory issues, risk aversion, transparency, fees, understanding/persistency of returns and lack of understanding of new asset classes.  According to Bryan Kelly, assistant professor of finance and Neubauer Family Faculty Fellow at the University of Chicago's Booth School of Business, the best hedges are debt derivatives and credit default swaps.  However, they are not liquid as they do not trade over central exchanges.  They are not considered safe investments such as AAA sovereign debt or gold for the risk averse.  The cost and fees associated with tail risk assets is another consideration.  Most investors know that it will lower expected returns and be volatile.  Another issue is the mismatch in time horizons.  Many products are short term and are being bought by long term investors such as pension funds.

Since the credit crisis, investing has been influenced more by macro economic events.  This will continue into the near future as we continue to hear about possible regional and global recessions, the breakup of the Eurozone, the US fiscal cliff and unrest in the Middle East.  Investors are trying to find the best hedges as 80% of them agree that managing tail risk is part of their investment planning.  71% believe that an event is likely to happen within one year and it will be worse than in the past.

The source for this article can be accessed here.

Asset Allocation Trends in Public Pensions

In the October 1, 2012 issue of Pensions & Investments, I noticed an interesting statistic in an article about the funding ratios of public pension plans.  The weighted average asset allocation of the top 100 plans in Pensions & Investments' universe for 2011 is as follows:

• US Equities - 21.6%
• Global Equities - 16.9%
• International Equities - 13.2%
• Fixed Income - 23.9%
• Private Equity - 7.5%
• Real Estate - 6.3%
• Hedge Funds - 2.3%
• Real Return - 1.2%
• Commodities - 0.4%
• Cash/Other - 4.4%

The target allocation for the same year was as follows:

• US Equities - 15.7%
• Global Equities - 23.6%
• International Equities - 9.7%
• Fixed Income - 25.2%
• Private Equity - 7.3%
• Real Estate - 7.6%
• Hedge Funds - 2.8%
• Real Return - 1.6%
• Commodities - 0.6%
• Cash/Other - 2.9%

The weighted average asset allocation 2007 is as follows:

• US Equities - 36.5%
• Global Equities - 6.0%
• International Equities - 17.4%
• Fixed Income - 25.3%
• Private Equity - 5.2%
• Real Estate - 5.7%
• Hedge Funds - 0.9%
• Commodities - 0.2%
• Cash/Other - 2.8%

The biggest losers from 2007 to 2011 were US and International Equities.  Global Equities, Private Equity, Real Estate, Hedge Funds, Real Return and Commodities were net gainers.  Based on the target allocations, we can expect more investment in Global Equities, Real Estate, Hedge Funds, Real Return and Commodities.

The source for this article can be accessed here.

Management Fees and Investor Alignment in Private Equity

In an article in Pensions & Investments, the Blackstone Group announced that it does not count management fees as one of the items that align general partner and investors' (i.e. limited partners) interests.  Instead, the company's investment in its own funds removes that issue - according to Steven Schwarzman, Blackstone founder, chairman and CEO.  During the company's twenty year history, it has invested $6 billion in its funds, alongside their clients.  For example, they committed $826 million in capital for the Blackstone Capital Partners VI LP, a $16 billion fund.

However, Blackstone is one of the few publicly traded private equity firms.  It is in the interest of management, who have large holdings of the stock, to maximize their management fees versus their performance fees.  The reason is that research analysts value these companies based on their management fees and/or assets under management.  Performance fees are too volatile and unpredictable to include in their analysis.  Instead of concentrating on a fund's performance, the company would be gathering assets.  Also, if performance fees are already high, there is less incentive to hit the hurdle.

Charging management fees was originally used to help private equity funds keep the lights on while investing capital.  For larger funds, the fees can be much more than the basic costs.  According to the Institutional Limited Partners Association, management fees should be based on reasonable operating expenses plus reasonable salaries.  In the second quarter of 2012, Blackstone had $373.4 million in fees, $113 million in expenses and $269 million in salaries.  Some institutional investors are pushing back on management fees and receiving fee discounts of 25 basis points if they invest $100 million or more.

The source for this article can be accessed here.

Effects of Pension Risk Transfer on Fund Managers

In the largest pension risk transfer deal of all time, General Motors offloaded $26 billion in pension liabilities to Prudential in exchange for $29 billion in assets.  This plan was executed in two stages.  First, a lump sum settlement was offered to 42,000 retirees which are about 33% of the entire beneficiaries.  For the rest of them, their pensions would be covered by annuities bought from Prudential.  The deal was created with help from Morgan Stanley, State Street and Oliver Wyman.  Other large corporations seeking to follow in General Motors’ footsteps are Alcatel-Lucent, Verizon, Ford and United Technologies.

With the rise of defined contribution plans like 401K’s, corporations have reduced or terminated their defined benefits plans.  Since 1975, the number had dropped from 250,000 to less than 30,000 – and 33% were frozen.  At the same time, pension funds have been reducing their risk profile by reducing their asset allocation to equities, doing buy-in deals (buying annuities to hold on their balance sheet) or buy-outs (doing a General Motors type of deal).  The giant deal is a harbinger of things to come.  In a survey of 500 global companies, Aon Hewitt discovered the following pension planning:

• 35% will offer lump sums to beneficiaries
• 6% will buy annuities to cover their payouts
• 6% will transfer their plan
• 4% will terminate their pension plan

Of the insurance companies involved in pension risk transfer, only Prudential and MetLife are able to take on General Motors-like transactions.  There is capacity to handle approximately $100 billion in pensions and General Motors has taken $26 billion of it.  Besides the big two, other firms that are participating in the business include MassMutual, Principal, American General and Mutual of Omaha.  Non-insurance companies such as JC Flowers and private equity firms are also targeting US companies.

These transactions may change the game in the financial services sector.  Asset managers of pension funds will lose assets to the insurers.  Managers specializing in long duration bond, liability driven investing, ETFs and alternative managers will gain.  So will consultants in risk transfer:  Aon Hewitt, Mercer and Towers Watson.  Corporate pensions currently hold twenty percent of US stocks.  As these assets are sold in exchange for bonds, there will be secular weakness in the stock market.  From a government point of view, the Pension Benefit Guaranty Corporation (PBGC) will be under pressure as only healthy pensions can transfer their risk, leaving underfunded pensions to be insured.

The source for this posting is the September 2012 article of ai-CIO.com.